September 04, 2014

One of the great promises of cryptocurrency networks such as those underlying Bitcoin and Ripple is that they will allow for the creation of a wide variety of economic applications that go far beyond transferring digital money. The "internet of money" refers to the capability of decentralized ledger networks to create unique types of transactions not involving banks, courts, and other traditional players.

Smart contracts are a potentially revolutionary type of application using decentralized ledger networks. The idea underlying smart contracts is that software can automate much of the contracting process. This could allow for the performance and enforcement of contractual promises without human involvement. To the extent smart contracts can automate the monitoring and verification of contractual performance, the costs of doing business will be reduced. Parties may also be able to more efficiently structure their relationships. For example, automatic verification of an employee's work could allow them to be paid more quickly and avoid unnecessary "face time" in the office.

The potential to greatly reduce or even eliminate the need for litigation and courts may be the most attractive feature of smart contracts. By using a smart contract, parties are committing themselves to be bound by its rules and processes. Doing so in principle removes the potential for parties to have a dispute. Both are held to the whatever outcome the smart contract determines. In his seminal 1997 article, the legal scholar and technologist Nick Szabo described what may happen to someone that breaches a smart car lease: "if the owner fails to make payments, the smart contract invokes the lien protocol, which [automatically] returns control of the car keys to the bank."

Smart contracts could therefore reduce the need for litigators, judges, and arbitrators. However, by requiring parties to strictly commit to decisions of a smart contract, the need for transactional attorneys and others to program smart contracts may increase. Parties would most likely want to specify a more detailed range of contingencies and outcomes ahead of time before committing themselves to abide by the decisions of a software-driven contract.

Smart Contracts in Development

Today, a wave of companies and organizations are developing smart contract platforms and applications. Bithalo, for example, appears to be nearly complete with a platform that uses a joint account system whereby the contracting parties deposit funds or work product into an account that cannot be accessed unless both parties consent. Tillit is another company developing a platform for executing business transactions over a decentralized ledger. Swarm, which uses the Counterparty platform, allows a company to crowdsource capital using "cryptoequity" contracts that give holders a variety of potential rights such as those relating to voting, sharing in profits, controlling executive decisions, and making further investments as the company reaches certain milestones.

Certain features have come to typify smart contracts. One is the use of multi-signatures (or "multi-sig") to improve performance. With a multi-sig feature, two or more parties are required to approve a transaction before funds can be released or some other aspect of the contract can move forward. Another is the use of an "oracle" to monitor prices, performance, or some other aspect of the real world. A smart employment contract may, for example, be automatically triggered once an oracle obtains information that an employee or independent contractor has completed providing a service. A major obstacle to the development of smart contracts is embedding this kind of decisionmaking into a cryptocurrency platform, something Ripple's Codius attempts to overcome.

A fundamental issue currently dividing smart contract developers is whether to build on top of the Bitcoin blockchain or to use a different cryptocurrency protocol. Ethereum, which raised the equivalent of about $12.7 million dollars over the summer, uses a blockchain distinct from Bitcoin. Using its own blockchain allows Ethereum to implement a wider variety of smart contracts, according to its founding white paper. The Clearhinghouse blockchain likewise considers not using Bitcoin to be a major advantage that enables faster transactions and no risk of being held up by choices made by Bitcoin developers. Earlier this year, the Counterparty platform noted that by limiting the amount of data that can be stored on the Bitcoin network, its developers rendered Counterparty's method of embedding message data useless.

How to Improve Smart Contracts

While smart contracts using cryptocurrency protocols could potentially revolutionize the world of contracting, they seem to assume that parties can determine all aspects of their bargain at the outset of their transaction. But in the real world, things aren't so simple.

Contracts often end up being ambiguous and imprecise. This is because what happens after parties strike a deal is often unpredictable. Parties also don't have the time or interest in attempting to detail every possible eventuality up front.

Parties accordingly want some level of flexibility and seek to avoid locking themselves into rigid commitments and outcomes. What developers of smart contracts seem to overlook is that both parties can benefit from renegotiating their contract in response to changed circumstances. For example, CBS and stars of The Big Bang Theory both benefited when some of the actors' contracts were renegotiated in response the show's immense rise in popularity--something not entirely predictable when the actors first signed on. Smart contracts should have mechanisms to allow parties to amend their agreements when mutually desired instead of being stuck based on old assumptions.

Contracting parties also desire built-in mechanisms that adjust the terms of an agreement without the need for renegotiation. Commercials loans often use performance pricing provisions that adjust the interest rate based upon the performance of the borrower. Asset-based loans can be particularly valuable because they automatically adjust the amount of credit available to borrower based on the value of its assets. Smart contracts should likewise have protocols that adjust the terms of an agreement to the advantage of both parties.

Smart contracting proposals should also learn from the automation that is already taking place in the contract world but outside of cryptocurrencies. In the context of international trade, banks have been trying to convince corporate clients to adopt bank payment obligations that effectively act like smart contracts: a seller is paid only if it transmits the correct data to a bank showing that the goods were shipped to the buyer. Companies have largely failed to adopt the system, however, due to not being sold on its benefits or wanting to convert to a new system.

And it is not as if the world of business contracts is completely paper based. Oracle's PeopleSoft platform automates much of the contracting process and related business operations. In the loan context, companies like ABLSoft and Ftrans enable lenders to continually monitor borrowers using their software. Much of promise of smart contracts may have already been captured.

If smart contracts using cryptocurrency networks are going to succeed, much less usher in a transactional revolution, they will have to overcome the problems of existing contract automation initiatives. They will also need to deliver features over and above those already being offered by companies that sell contract-enhancing software.